This High-Tech Darling Could Crash and Burn

Greetings. I'm back in Nevada (home sweet home), and trader extraordinaire Cash McDash is back in the saddle, too. This week, Cash admits to a moment of doubt -- don't worry, it quickly passed -- and then gives us the scoop on why tech darling VMware (VMW:NYSE) could be a great short. Don't miss it.

JL: Man, talk about a volatile finish to last week's action. Crude oil saw the biggest single-day jump in history, and now the index futures are under pre-opening pressure again even as we chat. How does all this affect Cash's world?

CASH: I tell you what, amigo, I just have to admit it. I actually had a moment of uncertainty this week.

JL: Stop the presses! You, the most confident trader on the planet, actually feeling a twinge of doubt? I wonder if that's a sign of the apocalypse or something.

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CASH: Har har. I know it's rare for me to travel light in the conviction department. But Thursday of last week really knocked me for a loop.

JL: How so?

CASH: Well, the last few weeks have been very quiet for both the IPO market and secondary offerings. The deals that did come to market were bogged down by selling, more often than not. There simply wasn't enough liquidity to soak up the additional supply of stock.

JL: Right. But you predicted all that stuff right here in our chats (and made some sweet short calls, too). So you're saying Thursday was different?

CASH: Exactly. That's why Thursday caught me off guard. If you'll remember, the Dow was 200 points higher on favorable economic reports, consumers were busting out the stimulus checks, and the market was celebrating a little.

JL: Then, on Friday, we got the jobs report, the oil spike and the big smackdown.

CASH: That shows why I was confused. Friday was much more in line with current market conditions, whereas the Thursday action was just bizarre. It was way out of place. And so I almost blinked. I started wondering if I had a loose screw, holding so many short positions with the market acting so happy.

JL: Ah ha, I see what happened here. You got head-faked, and you're just not used to it. Like playing defense on the basketball court, and seeing the point guard make a fast feint left before driving right. If the move is fast enough, the defender winds up dazed and confused.

Previously in the Cash McDash series:

Short This Highflier for Educational Trading Gains

Peeking Behind the Curtain With Cash McDash

An Ocean of New IPOs

Playing the Blinds With Cash McDash

The Beginning: Introducing Cash McDash

CASH: Seems like a fair analogy. I guess it happens to everyone from time to time. I can honestly say, though, that after a decade of trading, I've become a lot more comfortable hanging in there when my conviction is intact. And it certainly helps to be sitting on a big pile of gains that we've already booked for the year. I can afford to be wrong on a short-term basis when I've already made so much dough being right.

JL: Definitely a nice spot to be in. So getting back to the head-fake, what went through your mind on Friday? When the jobs report came out and suddenly everything reversed, I mean.

CASH: My brain was jammed with about a zillion thoughts, but I can tell you what came out of my mouth... "I KNEW IT! I KNEW IT! YEAH BABY!!!" Or something to that effect.

JL: Ah yes. I, too, have occasionally cheered and jeered the old trading screens at the top of my lungs. Kind of funny what you were cheering, though... the onset of some pretty bad news I mean. You're really crossing over to the dark side of the force.

CASH: Guilty as charged. But it was less a cheering of bad news, and more a feeling of relief. With Friday's turn, the picture came back into focus. It was a confirmation that I wasn't going crazy. And of course, it was nice to see my short positions back on track again.

JL: Speaking of shorts... Last week you started telling us why you're bearish on VMware (VMW:NYSE). I had to nip your long-windedness in the bud, but that's a conversation worth continuing.

CASH: Whoa whoa whoa, ME long-winded? Talk about the pot calling the kettle black!

JL: Ha ha, touche. Really though, I'm looking forward to your rationale for shorting a highflier like VMware. That stock made a lot of money for a lot of folks -- including you -- and so now it will be interesting to hear why it's setting up for a short candidate.

CASH: Okay, so as we covered last week, this is a company that was spun off from EMC. The IPO was in August of last year, and it was a smoking-hot deal. I had to pull all my strings and use every ounce of leverage I had to talk my guys into giving me stock. It turned out to be a sweet performer, and I made out like a bandit. I finally ended up selling the position for a triple-digit gain, and then sat back to see what would happen next.

JL: Dang. I wish we were having our little chats back then. That sounds great.

CASH: Don't worry, there will be plenty more where that came from... But in the meantime, there's money to be made on the downside as this highflier comes back to earth. Everyone's still excited about VMW. Despite a high multiple, analysts are keeping lofty price targets on the name.

JL: But those price targets are often just part of the marketing machine, right? Merrill Lynch, for example, might put out a "strong buy" for the sole purpose of pleasing company management, so that they choose Merrill as lead underwriter next time they issue stock. It's all about the fees and the politics.

CASH: Well put. And it also doesn't hurt that Merrill (and many other firms) collect brokerage commissions as their investing clients buy stock, based on Merrill's enthusiastic urging of what to buy. Once you see the game for what it is, you can use this
type of knowledge to your advantage.

JL: So what's the catalyst? What makes VMW fall from here.

CASH: A decrease in appetite.

JL: Huh? I thought these guys were software. How did we move to food?

CASH: No, no, I'm talking about risk appetite. See, when the market is rebounding, investors tend to increase their appetite for risk. They become more and more willing to bet the farm on a good story. After all, the market is moving up, companies are saying happy things, etcetera.

JL: Or so Wall Street would have us believe.

CASH: Right. But then when a jolt of sobering news comes in -- like, say, a drastic increase in unemployment, or a double-digit jump in the price of oil -- all of a sudden investors remember the downside.

JL: So let me clarify this for readers. Sometimes, even if nothing has materially changed for a company, investors will lower the price they're willing to pay for growth when general conditions get ugly.

CASH: You got it. And VMW is a prime candidate to get whacked because of the lofty valuation. Analysts expect VMware earnings to come in at $1.05 per share this year. Now, put aside the fact that $1.05 is probably way too aggressive. Just assuming the estimate is fair, would you be willing to pay 65 times earnings that amount in this risk-laden environment?

JL: Sixty-five bucks for every $1.05 in earnings, and the $1.05 a speculation at that? I'd have to have a pretty compelling reason to pay that kind of premium.

CASH: Exactly. And while earnings are expected to increase in 2009 and beyond, there are competitors entering the picture now. That could put a damper on the huge margins that VMware enjoys.

JL: The free market at work. Industries with fat profit margins tend to draw in more competition, which lowers prices and profit margins over time. Anything else?

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CASH: One more thing: VMware's primary customer draw is that it allows clients to lower their server and hardware costs. You'd be surprised how much these big corporations have to pay for their information technology setups. But as the cost of memory comes down, and other types of hardware and software get cheaper, too, the added savings benefit from VMware technology budget becomes less compelling. Their margins could get ground down by creeping price competition in that regard.

JL: Meanwhile, back at the ranch, the analysts are all as bullish as they can be. So imagine if the earnings estimates come down at the same time the market is accepting less risk and investors are shying away from nosebleed multiples...

CASH: Yeah, it has the potential to be a really, really, REALLY bad picture.

JL: So would you be short VMware here?

CASH: Not just yet, but maybe soon. I really want to see the stock close below $65 (which could be coming up here soon) before I pull the trigger. If we get there, I?d be comfortable going short with a stop above the $75 level. It could be a doozy of a trade.

JL: I love it. You always serve up the goods.

CASH: I tell you what. If you like this idea, then you'll really like what I've got in the kitty for next week. It's a great story, and I'm thinking the trading profits could pay for my next vacation.

JL: Disney World, here we come! Catch you next week.

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